The investing world can be scary. You’ve probably made investment mistakes, or know of someone who has. This is perfectly normal! Honestly, everyone has made investment mistakes – myself included. I bought medical marijuana penny stocks in college which did not turn out so well…
It is extremely difficult to give up control of our hard-earned money and invest in something that we can’t influence. When you are investing, you are hoping that your money will go up over time and provide you with a greater return than if it was just sitting in cash.
Investing boils down to an art and a science. The art refers to the emotional side of investing (also known as behavioral finance) and the science refers to the actual execution of investing. As technology continues to evolve, the science part of investing is becoming commoditized – you can receive a great investment portfolio for a really low cost.
However, the art of investing can be very difficult for someone to get right and this blog post outlines how to make sure you are doing the art piece right.
Why are you investing?
Before you can answer how, you need to answer why. A very common mistake of investing is jumping to the how without really knowing the why. “I want to grow my money!” is not a why. This is like saying “I want to travel!” Okay… where would you like to travel to? For how long? How much does that cost?
Now, this is surprisingly a very difficult question to answer. There is a lot to unpack, which is a very valuable role of a financial planner. A financial planner helps you and your partner articulate why money is important to you, what your dream life would look like if money wasn’t an obstacle and then determine how much that costs.
If you don’t go through the exercise of defining how much money you would need, you run the risk of continuously working and sacrificing time in the endless pursuit of money. This uncertainty of not having enough will cause you to keep working and building wealth at the expense of your precious time.
Here’s a starting point to ask yourself – imagine you are entirely financially independent. You have all the money you ever need and you wouldn’t have to work a day in your life. What would you do? What would you change? How would you spend your time?
Start big and then narrow in on what’s really important to you.
Determine your risk tolerance
Risk tolerance refers to the amount of investment risk you are willing to take with your money. Higher risk = higher expected return, but at the expense of more volatility.
There are two components of risk tolerance – your willingness to take risk and your capacity to take risk.
Your willingness to take risk
This aspect of risk is the most difficult for people because it’s tied to emotions and how you are hardwired. Most commonly, couples will have very different risk tolerances. One may be very comfortable with risk and one may be very risk adverse. This is something Financial DNA helps with – it brings awareness to how we are hardwired to feel about risk.
Your capacity to take risk
This aspect of risk is more objective. There are two components of risk capacity –the time horizon for your money and your career risk.
Time horizon refers to the amount of time your money will be invested until you want to start using it. If you start investing today and don’t plan on touching your money for 10 years, then your time horizon is 10 years. The longer your time horizon, the higher your capacity to take risk because you can easily stomach the market downturns along the journey.
On the other hand, career risk refers to your risk of earning money. The higher your career risk, the lower your capacity to take risk.
For example, take a doctor. Doctors will always be in demand and they have skills that are easily transferred to another hospital/private practice if they lost their job. They have low career risk, which means their risk capacity is higher with investments.
Now let’s say you left the 9 – 5 W-2 employee life and started a business. Well, now your career risk is higher because your income stream is uncertain. It will take time for your business to get up and running which means your risk of not having income is higher. In this case, your career risk is higher, which means your risk capacity is lower with investments.
So how do you determine your risk tolerance?
Carefully weigh both your willingness and your capacity to take risk. It’s quite common for these two to be opposite.
If you have a high risk capacity, but a low willingness to take risk, you would likely benefit from more investment education about how markets work, so you can feel more comfortable with the risk of investing. Your willingness to take risk is the component that is most easily changed with education.
However, if you have a low risk capacity, but a high willingness to take risk, you need to carefully weigh the downside risk of markets declining and your income going down. It can be difficult for people to take less risk when they are hardwired to take more.
Set your asset allocation
Asset allocation refers to how much money you are investing in risky assets (equities) and more safe assets (bonds). Remember, higher risk = higher expected return.
Once you determine your reason for investing and your risk tolerance, you then can decide how much risk to actually take. Unfortunately, it’s not enough to just decide the amount of risk, you also need to make sure you are investing in the right type of accounts that match your time horizon for withdrawing money. This graphic shows a good starting point.
This chart assumes that you prefer flexibility over tax-efficiency. This type of savings plan would allow you to withdraw money and experience your money throughout your life, not just starting at age 60 which IRS rules are designed around. In other words, you don’t buy into the work-until-65-mentality.
One of the most common mistakes that I see is people saving in the wrong type of accounts. This is a big reason why I recommend they diversify how they save so they don’t find themselves paying hefty tax and penalties if they use their money before age 60.
Choose your investment philosophy
In the investment world, there are two main philosophies – active and passive management. Active management refers to trying to “beat the market”. So, if the S&P 500 index returned 10% in a year, you would hope that your equity portfolio returned more than 10% in that year. Sounds great, right? Who wouldn’t want to do better than the market?
The reality is that active managers really stink at trying to beat the index. Here are some highlights from a 2018 SPIVA study:
- 24% of active managers beat the S&P 500 in 2018. Okay – so it’s possible!
- 13% of active managers beat the S&P 500 over a 3-year period. Oh… maybe not.
- 8% of active managers beat the S&P 500 over a 5-year period. Uh… so why would I try to find that 8%?
Enter passive management. Rather than trying to find the 8% of managers that performed better than the S&P over a 5-year period, you buy really low-cost index funds that track the S&P 500 or another index. Yes, it may not be as exciting as finding the 8% that perform better, but framed differently, you are doing better than 92% of people trying to outperform the market.
I spent nearly 1,000 hours studying and passing 3 brutal investment exams to learn all about investments when I earned the Chartered Financial Analyst (CFA) designation. It taught you all these complex ways to find undervalued companies, implement complex investment strategies and try to beat the market. Guess what? Most of the 92% of active managers have the CFA designation and still don’t beat the index.
Rather than paying higher fees and higher taxes to try and be the 8% to outperform, keep it simple, low-cost and be happy tracking the index.
Stick to your investment plan
The best, most well-thought-out investment plan in the entire world doesn’t work if you can’t stick to it. I’m referring to the emotional side of investing.
We are hardwired to buy more of things that bring us pleasure and less of things that cause us pain. Why do you think all of the Patriot’s coaches get hired by other NFL teams? The other NFL teams want more of what’s worked.
But… this is the opposite of buying low and selling high. When the market is tanking, we are hardwired to want to sell and reduce the pain of seeing our money go down. And once the market starts going up, we feel better and want to buy more!
Welcome to the roller coaster of investing. The most important investment decisions occur during the most painful situations. When the news is telling you that the market is tanking, you start doubting how your investments are allocated, yet it is so important not to abandon ship.
Check out this chart from JP Morgan:
If you missed the TEN BEST DAYS, or 0.27% of the days from 1999 – 2018, your annual return was 64% lower than if you stayed invested the whole time. How crazy is that??
When the market is in free fall, you should ask yourself – “have my core values, goals and fundamental reasons for investing changed?” If no – then you should not be changing your investment strategy
- Before you can answer how, you need to answer why. If you don’t, you’re taking a shot in the dark as it comes to investing.
- Discuss your risk tolerance with your partner. This likelihood is that you have different risk tolerance levels and it’s so important to have an investment plan you both can stick to.
- Keep. It. Simple. There is a common myth that as your money grows, your investments should become more complex. This couldn’t be further from the truth.
- If you do want to try to outperform the market, limit the exposure to a small piece of your portfolio. This is also referred to as the core-satellite approach. Have your core investments be low cost index funds and take some, small calculated risks elsewhere to try to find better performance. The likelihood is that it won’t succeed, but at least you limit the damage of being wrong.
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